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Forgiving Features for Failed Entrepreneurs vs. Cost of Financing inBankruptcies

Abstract

  • Anentrepreneur-friendly bankruptcy law lowers exit barriers by exposing failed entrepreneurs to comparatively less painful exit procedures. This in turn lowers the entry barriers and risks for entrepreneurs to launch new businesses. However, this reduced entry barrier may not come for free. From the standpoint of financial institutions a more lenient bankruptcy law means a higher risk of insolvency for their loans to entrepreneurs.

  • In this study we examine the relationship between two forgiving features of a bankruptcy law (i.e., fresh start in personal bankruptcy law and automatic stay of assets in corporate bankruptcy law) and the rate of new firm entry, as well as the mediating effect of the cost of financing. We use a cross-country database of 28 countries spanning 15 years. While these two features share the same forgiving nature, we find that providing failed entrepreneurs with a “fresh start” encourages new firm entry but providing entrepreneurs an opportunity to recover from troubling situations with an “automatic stay of assets” does not. Most importantly, both “fresh start” and “automatic stay of assets” give financial institutions incentives to charge higher interest rate (i.e., lending rate) to entrepreneurs; this in turn lowers the rate of new firm entry.

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Fig. 1

Notes

  1. Reorganization bankruptcy law under Chap. 11 includes partnerships.

  2. In many cases reorganization efforts take place before filing reorganization bankruptcy, particularly under pressure from creditors.

  3. We acknowledge that banks are not the only financial institutions that lend financial resources to entrepreneurs. However, other forms of financial institutions are exceptional rather than the norm. For example, in Europe only 13% of start-ups are supported by venture capital firms. Even in the United States start-ups backed by substantial venture capital are exceptional. Even Bill Gates (Microsoft) and Sam Walton (Wal-Mart), both highly successful entrepreneurs, initially pursued their entrepreneurial endeavors without venture capital support (Bhide2000).

  4. See Appendix A for the Sources of Bankruptcy Data (Claessens and Klapper2005). We thank Claessens and Klapper for sharing part of their data for our research.

  5. The 28 countries are: Argentina, Australia, Austria, Belgium, Canada, Chile, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Peru, Portugal, Singapore, South Korea, Spain, Sweden, Switzerland, Thailand, United Kingdom, and the United States. Since we do not have the same number of years available for each country the number of observations varies among countries. Due to missing variables (primarily from our dependent variable), we have an unbalanced panel of 131country-year observations for analyzing our hypotheses. See Appendix B for the structural characteristics (i.e., friendliness) of bankruptcy laws among the countries.

  6. The use of the procedures outlined in Baron and Kenny’s (1986) seminal work to test mediation hypotheses in the management literature has been prominent. See Shaver (2005) for details regarding the concerns, implications, and alternative strategies for testing mediational variables in management research.

  7. The model specification for estimating the lending rate: Prior research shows that the lending rate can reflect a variety of factors including (1) macroeconomic conditions, (2) market structure where the financial institutions operate, (3) overall financial structure or banking infrastructure, and the (4) risk and uncertainty levels of countries (Angbazo1997; Demirgüç-Kunt and Huizinga1999; Bennaceur and Goaied2008; Ho and Saunders1981). In order to examine the determinants of the lending rate in each country we therefore included variables such asreal GDP per capita,growth rate of GDP, andreal interest rate in order account for countries’ general levels of macroeconomic performance,market capitalization of listed companies (% of GDP) andtotal value of stock traded (% of GDP) to account for market structure,number of banks, bank capital to assets ratio, informal investments (% of GDP), and institutional investors’ financial assets in order to capture the variance and stability of countries’ banking infrastructures including the prevalence of informal investments, anduncertainty avoidance andbankruptcy rate in order to account for the variation in countries’ institutional environments.

  8. We would like to thank Armour and Cummings for sharing their data.

  9. The interest rate for each country is defined here as the real interest rate adjusted for inflation or price changes (Goderis and Ioannidou2008; Ndikumana2000). We measured inflation when computing the real interest rate using the change in the GDP-deflator. The computation of the real interest rate is: Since (1 + ireal) = (1 + inominal)/(1 + p), we can find the real interest rate as ireal = (inominal − p)/(1 + p) where I = interest rate and p = inflation rate.

  10. For example, in Japan where the stigma of failure is very high it is well known that bankrupt entrepreneurs often commit suicide (Time1999). Approximately 30 people commit suicide perday for economic reasons in Japan (Takahashi2003).

  11. Compared to funding from informal investors composed of family, friends, and foolhardy strangers (these are already accounted and controlled for), investments from professional venture capitalists as a source of equity funding for start-up entrepreneurs are quite rare and therefore less prominent (GEM2004). The sample size for this variable is also limited.

  12. Limited liability partnership (LLP) is also widely used in many countries, although it has only been recently used for some countries. For example, in Japan the legislation for LLP passed in (http://en.wikipedia.org/wiki/Limited_liability_company). We therefore reworked our analyses by dropping Japan, and we do not find the revised results to be qualitatively different from the original results.

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Appendices

Appendix A

Table 5 Sources of bankruptcy data in Claessens and Klapper (2005)

Appendix B

Table 6 New firm entry rate, interest rates, and forgiving features of bankruptcy law (Sources: Bae and Goyal2007; Claessens and Klapper2005; Doing Business Report; World Bank; Euromonitor, International Monetary Fund; La Porta et al.1998; OECD Data)

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Lee, SH., Yamakawa, Y. Forgiving Features for Failed Entrepreneurs vs. Cost of Financing inBankruptcies. Manag Int Rev 52, 49–79 (2012). https://doi.org/10.1007/s11575-011-0112-1

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Keywords

  • Bankruptcy law
  • Entrepreneurship
  • Failure